Monday, 14 November 2011

Iceland and the IMF: why the capital controls are entirely wrong

The IMF has emerged from the global crisis bigger and more powerful. But this column from VoxEU.org argues that the capital controls it required Iceland to adopt in 2008 are not of the soft and cuddly modern type that slow hot money flows. Instead they are akin to the draconian controls common in the 1950s. They violate the civil rights of Icelanders and significantly hamper economic growth.

Iceland was faced with a serious problem of hot money overhang following its crisis in 2008 and it was feared that speculators would head for the exits, causing an uncontrolled collapse in the exchange rate. In our view, this fear was unfounded. Any speculator exiting under those circumstances would have faced significant losses compared with the option of waiting for economic stabilisation and the consequent currency appreciation. After all, the currency approximately reached its long-term equilibrium rate immediately after the collapse.

Thus, in our view, the imposition of capital controls was both unnecessary and unjustified. Without them, the exchange rate might have temporarily fallen even further in a worst case scenario, in which case a surgical intervention in the form of a temporary tax on short capital outflows would have been a sufficient policy response.

Instead, the IMF forced the Icelandic government to impose draconian capital controls of a type last seen in developed economies in the 1950s, causing significant short-term and long-term economic damage. The capital controls were initially touted as a temporary measure, but now three years after the event it looks like they are there to stay, and as the domestic economy adapts to their presence, they will be increasingly costly to abolish. After all, the last time Iceland imposed capital controls in the 1930s, they lasted until 1993.

The capital controls have resulted in an intrusive licensing regime, with government permission required for foreign travel and those emigrating prevented from taking their assets with them. Both are direct violations of the civil rights of Icelandic citizens and Iceland’s international commitments as a democratic European country.

Our hope is that other countries facing a similar situation will have the good fortune of receiving better advice from the IMF.